Last Updated: 31 January 2023
In two recent feature articles (here and here) we’ve focused on the illiquidity that can affect exchange-traded funds when markets get volatile.
Recently, we pointed out that during August a number of ETFs and ETCs traded with average dealing spreads which exceeded the maximums permitted by the London Stock Exchange by some margin.
While this sounds like a breach of the rules, it may not be in practice. The exchange allows traders significant get-out clauses when markets become unstable. However, ETPs with recorded average spreads approaching or exceeding 100 percent are clearly illiquid and the publication of a maximum spread band of 1.5 percent, 3 percent or 5 percent for such a fund is misleading.
To help investors to avoid mistrades, Australia’s financial regulator recently suggested they should check funds’ indicative NAVs (iNAVs) before trading. This sounds like a good idea in theory. In practice, unless investors have access to a pricey Bloomberg data feed, they’ll be unable to do so. Exchanges’ and ETF issuers’ websites are also of little help in finding out a tracker’s intrinsic value (though some are better than others).
iNAVs are also inherently unreliable and are only as good as the underlying price source. During the worst part of the 2008 market collapse, the prices of corporate bond issues varied wildly, depending on whom you asked. One leading fixed income index provider told me that in October 2008 his firm received markedly different prices from two trading firms for the same financial sector bond. One said the bond was worth 20, the other valued it at 90.
Looking at the current shenanigans regarding the valuation of Greek government debt issues in European banks’ accounts, it’s hard to argue that things have got any better.
In a blog post published on Friday, “London Banker” argued that central banks need to take a much more forceful stance in ensuring that “capital assets are issued in fungible series, in size, and traded in transparent exchange markets with committed market makers”.
“Securities regulators have been under pressure for several decades to liberalise OTC markets, permit fragmentation to off-exchange trading systems, and turn a blind eye to issuance of securities in small, idiosyncratic offerings that will never liquidly trade except back through the offering investment banks,” London Banker continued. “The quality assurance and market conduct functions of exchanges have been eroded following demutualisation, and exchanges now are run for profit of their highly concentrated owners rather than in the public interest.”
“We should now be forcing assets back onto exchanges and force the exchanges to regulate quality and information norms,” the blogger concluded, suggesting that remutualisation or public ownership should be considered.
Whatever your view on exchanges’ organisation and ownership, there’s much more that they could be doing, in my view, to ensure that the ETPs they list are actually tradeable. This is arguably an increasingly urgent task, since there are signs that the illiquidity in some non-mainstream trackers is becoming acute.
ETF issuers, in common with active fund managers, have few incentives to stop launching funds. The reputational risks involved in creating an ETF that turns out to be illiquid are likely to be outweighed by the fees on offer if the fund works and assets flow in. Nor are ETF market makers likely to prove an obstacle to the listing of illiquid funds. While traders say that they let issuers know if a fund idea will be difficult for them to support, they’ll also tell you openly that they make the most money when markets are volatile and spreads widen.
So it’s up to the exchanges, in my view, to tighten up their rules and to ensure better protection for investors. Exchanges should be providing full, real-time iNAV information for all the funds they list, together with easy-to-use tools for measuring fund premiums and discounts, both actual and historical.
If market makers are unable to quote within maximum spread bands, exchanges should publicise this information immediately in the form of a risk warning for the affected trackers. If ETFs’ average dealing spreads fall outside target bands for a period of time, exchanges should give issuers and market makers a warning, then be prepared to delist the affected funds if things don’t improve. The performance of individual market makers and their maintenance of the two-way quote obligations that they sign up to should be audited and reported publicly.
“Markets are at the heart of successful civilisations. Markets require quality norms, information publication, and price transparency to operate effectively,” argued London Banker. It’s hard to argue with this. For the exchange-traded fund market, recent evidence suggests there’s plenty to be done to ensure that these trackers live up to the first and second words of their name.